Bonds are a great way to add fixed income to an investment portfolio, and while many consider them to be less volatile than stocks, there are inherent risks with both corporate and government bonds. Credit, interest rate and reinvestment risks are a few to consider.
When a bond is purchased, the buyer is essentially lending money to an entity, corporation or government that promises to pay back the funds over a specific period at a fixed interest rate. An important factor to consider is the possibility of default, particularly with corporate bonds. Unlike U.S. Treasury Bonds, corporate bonds are not backed by the “full faith and credit” of the U.S. government. Understanding a company’s ability to meet its financial obligations can go a long way in assessing credit risk.
Generally speaking, when interest rates rise, the prices of existing bonds fall, as does the market demand. On the contrary, during a falling interest rate environment, the demand for existing bonds increases as investors seek higher yields for their portfolios. Depending upon interest rates and a bond’s credit status, its market price may be at, above, or below its par value (face value).
Assume an investor owns a bond yielding 3 percent at par value and interest rates rise suddenly to 4 percent. The investor’s bond is now worth less in the marketplace and would have to be offered below par in order to attract a buyer. Should interest rates instead fall to 2 percent, the bond could be valued above par and command a premium in the marketplace.
U.S. Treasuries, considered to be the safest of all investments, and corporate bonds are subject to interest rate risk as well as reinvestment rate risk. For example, a 30-year U.S. Treasury zero-coupon bond has much more interest rate risk than a shorter term 2-year corporate bond. As bonds mature and coupon payments are received, opportunities to reinvest in similar type bonds may not be available. This is particularly true in a falling interest rate environment, and the investor may have to reinvest at a lower rate than the original investment.
It is also important to consider a bond’s “duration,” which is its sensitivity to interest rate fluctuations. When comparing two bonds with similar maturities, the one with the higher yield will typically have a shorter duration and in turn be less sensitive to interest rate vacillations. U.S. Treasury Bonds tend to be more rate sensitive when compared to corporate bonds with similar maturities. This is because a corporate bond is typically going to offer a higher yield than a lower risk U.S. Treasury Bond.
To help reduce the level of risk in the fixed-income portion of a portfolio, consider owning a diverse mix of bond types and maturities. This can be accomplished by constructing a “bond ladder,” which is a portfolio of bonds with maturities that are spaced at regular intervals over a certain number of years. This investment strategy can vary in size and structure and include a variety of bonds depending on an investor’s time horizon, risk tolerance and goals. When short-term bonds from the lowest rung of the ladder mature, the funds are often reinvested at the top end of the ladder. This strategy may also increase cash flow if new issues are offering higher yields. A ladder can also be part of a withdrawal strategy in which the returned principal from maturing bonds provides retirement income.
Building a ladder with individual bonds can provide certainty as long as the bonds are held until maturity. Keep in mind that this type of strategy does come at a cost, with bonds generally sold in increments of $5,000 or more. Diversification is key within a bond ladder. While this strategy does not guarantee profits or protection against possible loss of investment, it can go a long way in helping to manage the overall risk of the investment portfolio.
John O’Rourke is First American Bank’s Private Banker and Wealth Advisor for South Florida. As a relationship manager for high net-worth individuals and their companies, he assists clients and family members with a variety of banking and wealth advisory needs. If you have any questions or comments, contact John at Jorourke@firstambank.com. First American Bank investment products are Not FDIC Insured, Not Bank Guaranteed, and May Lose Value.
